The Effect of Cannabis Company Tax Liabilities on an Income Approach Valuation
The growing, sale, and use (medicinally and recreationally) of cannabis remains illegal at the federal level in the US. However, growing, selling, and using cannabis is legal in several US states. In terms of the taxation of cannabis companies on the federal level, the Internal Revenue Code Section 280E states:
“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
Since cannabis is classified as a controlled substance on the federal level, cannabis companies pay federal income tax based on their gross profit rather than their net income. This can have a significant impact on value when utilizing an income approach.
In valuation, the income approach utilizes either historical or forecasted financials to determine the cash flows, or dividend-paying capacity, a company will generate that can be utilized by an owner or investor. A larger tax liability decreases available cash flows for owners and investors.
Below is an example of how the tax liabilities of cannabis companies impact their value when utilizing the income approach. Our example includes two companies with identical income statements. Company A is a cannabis company, while Company B is a restaurant.
For Company A, the cannabis company, assume a 21% federal tax and a 7% state tax:
- Federal tax liability is based on gross profit.
- Total federal and state tax liability: $851,200.
- Net cash flows after taxes: $148,800 ($1,000,000 – $851,200).
For Company B, the restaurant, with the same tax rates:
- Federal tax liability is based on net income.
- Total federal and state tax liability: $265,300.
- Net cash flows after taxes: $734,700 ($1,000,000 – $265,300).
This means Company B has $585,900 more in cash flows available to owners or investors than Company A. If both companies have a capitalization multiple of 5, Company B would be valued almost $2,929,500 more than Company A.
As this example demonstrates, the tax liabilities of cannabis companies can have a substantial impact on their valuation under the income approach.
FAZ has conducted several valuation engagements related to cannabis companies, ranging from consulting on creating defendable forecasts to valuations for raising equity, selling shares, and gifting shares.